Cost of goods sold: What it is and how to calculate COGS for your small business

Published Wednesday 26 November 2025

Table of contents

• What is COGS?
• How to calculate COGS
• Examples of COGS
• COGS and different business models
• Why COGS is important for small businesses
• Tips for managing and reducing COGS
• COGS accounting methods
• FAQs on COGS

Key takeaways

• Calculate COGS using the appropriate formula for your business type—retailers use beginning inventory plus purchases minus ending inventory, while manufacturers include raw materials, direct labour, and manufacturing overheads.

• Negotiate with suppliers regularly and streamline production processes to reduce COGS, as every £1 reduction in these costs directly increases your gross profit margin.

• Choose your inventory valuation method carefully (FIFO, average cost, or specific identification) because it significantly affects your COGS calculation, financial statements, and tax obligations.

• Track COGS consistently to set profitable pricing above your direct costs and make informed decisions about inventory management, product mix, and business growth strategies.

What is COGS?

Cost of Goods Sold (COGS) is the direct cost to produce or purchase the goods you sell. It represents the money you spend specifically on creating your products.

What COGS includes:

• Direct materials: Raw materials and components used in production
• Direct labour: Wages for workers directly involved in manufacturing
• Manufacturing overheads: Factory costs like utilities and equipment maintenance

Additional costs some businesses include:

• Freight and storage: Shipping and warehousing expenses
• Transaction fees: Payment processing costs for sales
• Sales commissions: Direct selling expenses (for some business models)

Some businesses, such as ecommerce businesses, also include freight, storage, sales commissions, or transaction fees if they relate to the costs of selling products.

What COGS excludes:

• Indirect expenses: Rent, marketing, administrative costs
• General salaries: Management and office staff wages

Use accounting software to track COGS, manage your expenses, and manage your inventory.

How to calculate COGS

COGS calculation methods depend on your business type. Retailers typically use inventory-based formulas, while manufacturers calculate based on production costs.

Cost of goods sold formula used by retailers for inventory accounting.

Retail COGS formula

Where:

• Beginning inventory is the value of inventory at the start of the period
• Purchases is the cost of inventory acquired during the period
• Ending inventory is the value of inventory remaining at the end of the period

The COGS calculation does not use the number of sales – it focuses on the value of inventory at the start and end of the period. This approach helps you account for discarded inventory.

If you manufacture goods, you may need to add up all the costs on your product's journey to the customer. Some manufacturers choose not to count warehousing or freight.

Manufacturing COGS formula

Where:

• Raw materials: the direct materials used to produce goods
• Manufacturing costs: costs of production
• Storage costs: expenses from inventory storage
• Freight: any shipping costs for incoming materials or final delivery

If you use accounting software like Xero, you can find COGS in the profit and loss (P&L) or income sections of your financial statements.

Examples of COGS

A retail business holds £10,000 of inventory at the beginning of the quarter, and it buys £25,000 during the quarter. At the end, it owns £8,000.

The equation is:

£10,000 + £25,000 − £8,000 = £27,000

A manufacturing business buys £7,000 worth of materials and spends £3,000 of energy and labour, turning it into goods, plus £1,200 on shipping.

The equation is:

£7,000 + £3,000 + £1,200 = £11,200

COGS and different business models

You calculate COGS differently depending on your business model. For example:

• Manufacturers tend to include certain indirect costs, such as material handling costs, with official guidance allowing for a reasonable proportion of costs indirectly attributable to production to be included in the value of an asset.
• While retailers often calculate COGS using starting and ending inventory for a period, those with many rapidly changing items may find it more practical to value stock at its current selling price less the normal gross profit margin.
• Service businesses are more likely to include labour

Why COGS is important for small businesses

COGS tracking helps you set profitable prices and protect your margins. Understanding your true costs ensures you price competitively while maintaining profitability.

Key benefits

• Accurate pricing: Know exactly what markup you need for profit
• Cost awareness: Identify hidden expenses that affect margins
• Growth planning: Anticipate cost changes as you scale operations

Common cost surprises for growing businesses

• Facility upgrades: Moving from home-based to dedicated premises
• Material handling: Additional logistics and storage costs
• Compliance expenses: New regulations as you expand

COGS also helps you make better business decisions in four key areas.

Pricing

COGS determines your minimum price point – you must price above COGS to generate profit. Tracking COGS helps you respond quickly to cost changes and maintain healthy margins.

Pricing benefits:

• Profit protection: Ensure every sale covers direct costs
• Price adjustment timing: Know when rising costs require price increases
• Competitive positioning: Price strategically while maintaining profitability

Profitability

Lower COGS equals higher profits – reducing your cost of goods sold directly increases your gross profit margin when you keep the same selling prices.

Profitability impact:

• Direct relationship: Every £1 reduction in COGS adds £1 to gross profit
• Compound effect: Small COGS improvements create significant profit gains
• Margin improvement: Better COGS control strengthens overall business margins

COGS affects gross profit, but your net profit also depends on operating expenses like rent, wages, and marketing costs.

Inventory management

Use COGS analysis to assess your inventory efficiency and spot slow-moving items. This helps you optimise stock levels, reorder points, and your product mix to balance demand and reduce capital tied up in goods.

Taxes

COGS is a deductible business expense. Track and document all COGS components to maximise deductions and provide audit documents.

Check with your local tax authority for how they handle COGS.

Understanding your financial health

Understanding COGS is key to calculating your profit margins to build a secure business.

Strategic decision-making

With a close eye on COGS accounting, you can make better decisions. COGS gives you the context for strategic financial analysis to inform decisions like investing in new product lines, automation, or new distribution methods.

Tips for managing and reducing COGS

Use these tips to help effectively manage and reduce COGS.

Negotiate with suppliers

Negotiate with suppliers to reduce your COGS through better pricing and terms.

Negotiation strategies:

• Regular price reviews: Schedule quarterly discussions about rates
• Volume discounts: Negotiate lower prices for bulk orders
• Long-term contracts: Lock in favourable rates with extended agreements
• Competitive bidding: Compare multiple suppliers for better deals
• Payment terms: Negotiate early payment discounts

Streamline production processes

Analyse your production workflow to identify inefficiencies and reduce waste. Consider investing in automation to decrease labour costs and increase output consistency, but assess the effects on COGS and return on investment (ROI).

Optimise inventory levels

Use data analytics to accurately forecast demand so you can keep inventory levels optimal. Regularly review your product mix and consider discontinuing slow-moving items.

Reduce freight costs

Explore alternative shipping methods that balance cost and delivery time. Consolidate shipments to access bulk shipping rates. Negotiate with carriers for volume discounts or use a third-party logistics provider to optimise your shipping.

COGS accounting methods

Inventory valuation methods determine how you calculate COGS and directly impact your reported profits. The method you choose affects which costs count as COGS and which stay in inventory.

How it works:

• Cost transfer: Inventory costs move to COGS when items are sold
• Method impact: Different approaches assign different costs to sold goods
• Profit effect: Your chosen method influences gross profit calculations
• Financial reporting: Methods affect both balance sheet and income statement

FIFO (first in, first out) method

FIFO assumes that the oldest inventory items are sold first. This method often results in COGS that matches the physical flow of goods. When prices rise, FIFO usually leads to lower COGS and higher reported profits. In contrast, methods that use higher recent costs can show lower profits, as seen in a historical tax case during a period of rising prices showed a lower profit.

LIFO (last in, first out) method

LIFO assumes the most recently acquired inventory is sold first. This can lead to higher COGS and lower profits during inflation. LIFO is not permitted under International Financial Reporting Standards (IFRS) and is disallowed in many countries outside the United States. For example, UK accounting standards specifically prohibit the use of LIFO.

Average cost method

This method uses the weighted average inventory costs of individual items to value both COGS and ending inventory. It smooths out price fluctuations and is a middle ground between FIFO and LIFO.

Specific identification method

This method tracks the actual cost of each inventory item. It's typically used for high-value items. While accurate, it can be impractical for businesses with large quantities of similar items.

FAQs on COGS

Here are common questions and answers about COGS that your small business can consider.

What's the difference between COGS and operating expenses?

COGS is the direct costs of creating products while operating expenses are the indirect costs of running the business (rent, marketing, staff, etc.).

What is the difference between cost of goods sold and cost of sales?

These are often used interchangeably. However, COGS focuses on the direct costs of creating or purchasing products that are sold. Cost of sales (COS) sometimes includes those costs plus additional business expenses linked to revenue generation, such as transaction fees, sales commissions, or acquisition costs in some digital businesses.

Can I estimate my COGS?

Yes, you can use estimates, especially if you're a new business or have limited resources. As your business grows, you'll want to track COGS accurately as it directly affects your profitability and taxes.

Are salaries included in COGS?

Yes, even service businesses have COGS. While you're not selling physical goods, COGS can include the labour costs, software subscriptions, or materials you use to deliver the service.